Basic Portfolio Construction

If you’re like me, your exposure to the investing process probably conjures up thoughts of picking individual stocks–occasionally spurred by colorful TV pundits. They have us believe that with a little hard work we can become stock picking experts just like they are! My experience has been that this is much more difficult than it appears. At one point I tried to select superior fund managers and shared some of the outcomes. Needless to say I wound up with mixed results. Some managers were good, others were horrible, all charged high fees (north of 1%). Instead of picking stocks I was picking managers, and at the end of the day I was no better off. So here’s the fundamental problem: How does one go about constructing a long-term investment portfolio? I ultimately arrived at three requirements:

Strategy must be very long-term (30+ years), practical, and easily implemented

Exist independent of a specific manager

Provide a reasonable rate of return

My proclivity to avoid actively managed funds is driven by more than a few bad experiences. For over a decade Standard & Poors has compiled statistics comparing actively managed mutual funds to their respective benchmark index. As you might guess, the actively managed set hasn’t done very well. The year-end 2014 scorecard showed 86% of large cap fund managers failed to deliver returns above their respective benchmark. This poor performance was not limited to single years as fund managers have performed just as poorly over longer periods of time. From the January 2016 Persistence Scorecard summary:

According to the S&P Persistence Scorecard, relatively few funds consistently stay at the top. Out of 678 domestic equity funds that were in the top quartile as of September 2013, only 4.28% managed to stay in the top quartile by the end of September 2015. Furthermore, 1.19% of the large-cap funds, 6.32% of the mid-cap funds, and 5.41% of the small-cap funds remained in the top quartile.

These are just a few examples. A more in depth review of the scorecards shows results for actively managed mutual funds are pretty dismal regardless of market segment. Additionally the results are fairly consistent year after year. Given this information I consider my avoidance of actively managed funds to be rooted in evidence, not opinion and emotions. Let’s keep in mind that these guys are “the pros.” They have access to resources and information that I can only dream of. If they can’t beat the market on a consistent basis, what chance do I have?

The other problem I encountered with actively managed funds is one of mortality. Even excellent managers will eventually retire, leaving me with the task of finding another good one. Based on the numbers above the odds of finding a manger who can match or beat the market index isn’t so good.

When it comes to returns I think it makes sense to consider what is reasonable. I previously looked at aggregate stock market returns and in the long-run the rate of return has been a little under ten percent. Over thirty-five year periods the return has historically averaged between 8% and 13%. I generally like to take a conservative approach and for planning purposes and I estimate an 8% rate of return over 30+ year periods of time.

Let’s keep in mind that this is a very long-term rate of return. Returns can vary–by quite a big range–year over year. US large company stocks, in aggregate, had their worst year in 1931 when they declined by 43%. On the other hand they had their best year in 1933 returning almost 54%.

It’s difficult to discuss rates of return without getting into a discussion on risk as the two typically go hand-in-hand. In the academic sense risk is typically quantified as the historic standard deviation of returns. This is simply a measure of how much returns will vary from year to year and is occasionally referred to as volatility. Some would argue that there’s much more to risk than a simple mathematical measurement, but that’s a separate discussion. For the sake of simplicity risk, standard deviation and volatility are essentially synonymous. Here are some examples of various asset classes that are available through index funds along with their historic rates of return and volatility

Asset

Annualized
Return

Volatility
(Std Dev)

US Large Co. Stocks

10.0%

18.9%

US Small Co. Stocks

12.0%

28.5%

Intl. Developed Market Stocks

9.5%

17.0%

Real Estate Investment Trusts (REITs)

12.0%

17.0%

Treasury Bills

3.5%

0.9%

Treasury Notes

5.2%

4.4%

Treasury Bonds

5.6%

8.4%

Corporate Bonds

6.1%

7.5%

The solution that I arrived at, for myself, was to simply buy the index. By simply accepting the “market rate of return” I’ve instantly outperformed the majority of fund manangers. For this reason, combined with low fees, index funds have proliferated the personal investing space in the past decade or so. They are typically composed of tens if not hundreds or even thousands of different stocks providing an exceptional level of inexpensive diversification. No need to individually purchase a large basket of stocks. Furthermore, these funds are available in a variety of flavors based on the underlying assets that they hold. This makes it exceptionally easy to diversify not just among many different individual stocks, but also among different groups of stocks and bonds. The advantage of owning stocks and bonds from different economies and sectors takes advantage of diversification on a higher level.

Most of us have heard the phrase “Don’t put all your eggs in one basket.” Broadly speaking diversification simply means holding more than one asset. But simply holding more than one asset isn’t really sufficient to actually achieve diversification. What investors are really after is a way to prevent a poorly performing asset from taking down their entire portfolio. Thus diversification is a strategy to reduce risk. However, in order to effectively diversify a portfolio it needs to be composed of assets that behave independently of each other. The ability to behave independently can actually be measured–at least historically–using correlation coefficients. Here’s what the historic correlation coefficients look like for several major asset classes

A correlation coefficient of 1 indicates that two assets behave identically. Zero means they behave independently. In reality, most stock asset classes wind up somewhere between 0 and 1 while bonds tend to have very low correlations to stocks. Ideally a portfolio should be composed of multiple assets that have very low correlation coefficients. This reduces the chance of the overall portfolio suffering a substantial decline in value when one asset does poorly. However, it’s very difficult to find multiple assets that behave truly independently of one another.

The concepts of risk, return and correlation are the basic metrics necessary to understand asset behavior. The bread and butter of portfolio construction combines these three metrics to understand how a given asset impacts the overall portfolio. The primary task in asset allocation strategy is to determine how much of a given asset should be included in a portfolio. Various combinations of different assets can and should be considered. For instance, the historic returns and volatility of US large company stocks and Treasury Notes can be combined in various proportions and charted in the following way

The chart above is commonly referred to as the efficient frontier. In theory it shows the maximum return that was achieved for a given level of volatility (sometimes referred to as risk). A word of caution is required when working with models such as these. It would appear to be easy to optimize a portfolio around a precise rate of return and volatility. However, the chart above was generated using historic returns data and the future is unlikely to look like the past. Rates of return, volatility and correlation coefficients can all change over time. Using past data to forecast an ideal optimal allocation for the future can be disasterous. Here’s what the efficient frontier looks like decade-by-decade

That doesn’t mean efficient frontier models are completely useless. To quote statistician George Box: “All models are wrong, but some are useful.” There are a few things that can be taken away from these models to inform better portfolio construction:

Higher returns usually require that a portfolio take on a higher level of volatility.

Even the most risk averse investors can benefit from owning some stocks as it will increase return with a neglible increase in volatilty.

Decreasing stocks slightly and holding some bonds provides a substantial reduction in volatility with only a small impact on returns.

As mentioned before, different stock/equity asset classes tend to be highly correlated with each other. In other words, they behave in a similar fashion. Financial advisor William Bernstein ran an experiment comparing portfolios composed of randomly selected allocations to different classes of stocks and bonds. His conclusion:

To summarize, then, over the very long term your overall percentage exposure to equity is of primary importance. Your precise global stock allocation is not. Your choice of bond duration is important only if bonds make up the largest part of your portfolio. [5]

In other words, there are really two asset classes: stocks and bonds. The most important decision to make when constructing a portfolio is the percentage allocated to each of these two assets. Less important is the allocation to domestic stocks versus international stocks.

The most difficult part of this is that there no one correct answer. A portfolio should be constructed in attempt to achieve a certain goal, which dictates the required rate of return and the amount of risk that is required. For this reason everyone will have different preferences and different allocations to different assets within their portfolios.